The Fed Doubles The Dosage

Written by Richard Duncan | Saturday, December 15, 2012

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On December 12th, the Federal Reserve announced the most aggressive program of monetary stimulus ever undertaken in peacetime. Beginning in January, the Fed will more than double the amount of fiat money it creates each month from $40 billion to $85 billion. On an annualized basis that amounts to more than $1 trillion a year. This week we will consider 1) What they did; 2) Why they did it; and, 3) What impact it will have on asset prices over the short-term.

What They Did:

In a nutshell, the Fed announced it will more than double the amount of fiat money it creates each month and that it will use that money to buy government bonds and mortgage-backed securities until the unemployment rate drops substantially or until the inflation rate accelerates. The press release stated:

“…the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities … initially at a pace of $45 billion per month.”

Take note of the word “initially”. That strongly suggests the Fed may soon increase the amount of money creation beyond $85 billion a month.

Furthermore, the Fed also pledged to keep the federal funds rate at 0 – ¼ percent “at least as long as the unemployment rate remains above 6 ½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

In other words, the Fed intends to keep interest rates near zero percent and to continue creating fiat money at an annual rate of $1 trillion (or more) a year until it succeeds in bringing down unemployment or until inflation becomes a threat.

Why They Did It:

I believe the Fed took these unprecedented steps because it is terrified the world is dangerously close to spiraling into a new great depression. As I have explained before, credit growth in the US has fuelled economic growth in the US and, therefore, the world since World War II. Since 1952, any time total credit (adjusted for inflation) expanded by less than 2% during a year, the US economy has gone into recession. Now, it is not increasing at all. Consequently, the US economy is very weak. Imports into the US were no greater in the third quarter of 2012 than in the third quarter of 2011. US imports have acted as the driver of global economic growth since the 1980s. Now, with imports flat, world trade has ceased to expand – and there is a very real danger that it will begin to contract. The Fed hopes that its money creation will spur credit creation by pushing down interest rates and by pushing up asset prices, thereby, preventing a downward spiral into depression.

The Fed’s fears have been exacerbated by the danger posed by the “fiscal cliff”. Even if this politically induced fiasco turns out to be only a fiscal ditch (as I expect it will), it will still inflict at least some damage on the economy in 2013 and beyond.

What Impact Will It Have?:

The Quantity Theory Of Money states that any time the quantity of money is increased, it will cause inflation. But there are different kinds of inflation. What kind of inflation will QE 3 cause?

I expect it to cause asset price inflation. As the Fed creates money and buys $85 billion worth of assets each month, that money will be reinvested into other assets and push up their price. That is certainly what the Fed hopes will happen. That is what QE 3 is designed to do. Therefore, the price of stocks, bonds and real estate should appreciate.

I also expect commodity price inflation. The price of food and metals – including gold and silver – seem likely to move up. The near-term direction of oil is less certain given the enormous surge in oil production in North America and the rapid development of alternative energies that will eventually drive the price of oil sharply lower.

The expanding supply of dollars should exert downward pressure on the value of the dollar relative to other currencies – unless the central banks of other countries follow the Fed’s example and expand the quantity of their currencies as well. It is highly probable that many central banks will choose that course – creating money to buy assets denominated in their own currencies to boost their domestic asset prices or else to buy dollars in order to prevent their currencies from appreciating to protect their export industries. In either case, this will further add to global liquidity, resulting in still more asset price and commodity price inflation.

Thus, the Fed’s strategy of creating more money should succeed in stimulating the global economy in the near term by inflating new asset price bubbles that create a “wealth effect” that underpins consumption. This strategy cannot succeed over the long run however unless accompanied by additional policies that boost median income in the US and globally. Unless wages rise, the public will soon once again be incapable of paying the interest on the money they borrowed to purchase the inflating assets. Then the asset price bubbles will pop and a new and much worse crisis will ensue.

Economic management through bubble creation is not a viable long-term solution to a global crisis caused by unchecked, credit-induced economic bubbles.